The sanctions against Russia are working; but not for Russia, Ukraine, the EU, or even the US.

In the 2nd quarter, Russia’s GDP contracted 4.6 percent from a year earlier, following a 2.2 percent contraction in the 1st quarter. A severe contraction was expected after the selloff in oil, currency crisis and the consequent plunge of consumer demand. But the plunge was worse than anticipated and most since 2009.

As Moscow has struggled to speed up the diversification of its industrial structure and to defuse the repercussions of the plunging energy prices, it has also sought to shift its economic relationships from the transatlantic axis to the East. Nevertheless, in the past 12 months, the ruble has depreciated over 43 percent against the dollar.

In Washington, the consensus is that “the sanctions are working.” However, the question is, for whom?

Sanctions unified Russia

In March 2014, Washington and Brussels initiated sanctions against Russian individuals and interests in response to developments in Crimea and Eastern Ukraine. For 1.5 years, the hope has been that sanctions and the Ukraine crisis would quash President Putin’s popularity. In reality, Ukraine has been pushed close to default, while the sanctions have united Russians behind Putin.

Before the Ukraine crisis, diminished economic prospects caused Putin’s approval rating to plunge to 61 percent; the lowest since 2000. In 2014, the sanctions and the annexation of Crimea galvanised public opinion behind Moscow. Today, Putin’s approval ratings remain at 87 percent, according to Levada Center.

Currently, some 56 percent of Russians support Putin’s “Unified Russia” Party, while communists, militant and nationalists, and social-democrats together have about 15 percent, according to the Russian Public Opinion Research Center.

In the US, many observers suspect that putinism and statism are on the rise because barely 65 percent of Russians support the prime minister and the government, and just 45 percent are behind the parliament. However, that’s a tricky argument. After all, in the US, the approval of the Obama administration and the Congress is about 40% and 15%, respectively, according to public polls and Gallup. In other words, president Obama’s support in the US is barely half of that of Putin’s in Russia. Even worse, the support of the parliament in Russia is three times higher than that of Congress in the US.

In reality, Putin’s actions reflect the wishes of the Russian people, including the moderate majority and the emerging middle classes.

Yet, the West continues to rely on the idea that “Putin is the problem, Russia is with us.” In reality, Putin’s actions reflect the wishes of the Russian people, including the moderate majority and the emerging middle classes. Before the global crisis, the latter accounted for almost fifth of the population; today, only a half or a third of that.

Months of sanctions have hardened sentiments across-the board and on all sides. In Russia, moderate centrists have turned into assertive nationalists and informed social-democrats into passionate communists.

Before the sanctions, more than half of Russians held positive views of America. Today, that figure has plunged to just 15 percent. Similarly, support for President Obama in Russia has fallen from 40 percent to barely 11 percent, according to Pew. In turn, the number of Americans who see Russia as US’s greatest enemy has doubled to 18 percent.

These findings come amid rising, but diverging tensions between Russia, Ukraine, the US and Europe. Brussels is not eager to extend further sanctions in the near term but nor will it readily remove them.

In the US, the 2016 presidential campaigns are likely to increase anti-Putin volume, while members of the Congress have proposed extreme actions, which range from declaring Russia in breach of its obligations under the nuclear treaty (INF) to ousting Moscow from the World Trade Organization.

Unfortunately, the implications of the sanctions seem to remain poorly understood in the US. One reason is the huge gap between US self-perceptions and international perceptions of the US. According to Gallup, only 2 percent of Americans see the US as the “greatest threat to peace” – as against every fourth person globally.

From hopes of détente to new Cold War

Today, contemporary ‘Russologists’ seek to outperform each other with “doom and gloom” forecasts. Nightmare scenarios are fashionable and sell well. Nor can they any longer be discounted. After all, Moscow is vulnerable to broadening sanctions, plunging energy prices, the fall of the ruble and rising inflation.

But was Russia’s new contraction inevitable, or “natural”?

The simple answer is no. Earlier in the spring when oil prices seemed to recover, Russia’s outlook still had substantial potential, as I argued then. If, at the start of the year, you would have invested in Russia, you would have walked away with comfortable risk-adjusted returns half a year later.

The country continues to have strong turnaround potential, as evidenced by its best gains relative to other BRICS, based on Bloomberg data.

The more complex question is whether Russia’s new contraction is even desirable; even to those Western interests that support sanctions. This presumes that the purpose of the Western sanctions is to use sticks and carrots to limit Moscow policy directions in ways that serve Western interests and those of Russian people.

In contrast, some critics of the sanctions argue that the ultimate objective is not to encourage pro-market policies in Russia but to clip Russia’s economic future. These skeptics include Stephen F. Cohen, a leading Russia expert who warned already in 2006 that “US-Russian relations had deteriorated so badly they should now be understood as a new Cold War – or possibly as a continuation of the old one.”

Today, most economic and geopolitical evidence points toward the decreasing probability of détente and increasing likelihood of a new Cold War.

Toward 3%+ contraction

In the pre-sanctions Russia, growth was expected to remain weak in 2014-15, due to stagnant oil demand, while institutional weaknesses reflected a poor investment climate. Even in early 2014, markets still projected growth of 1.7 percent that year and 2.3 percent in 2015.

Those forecasts are now hollow dreams that few care to recall. After months of sanctions, Russian economy contracted by 3.5 percent last year. During the ongoing year, another contraction of up to 3-3.4 percent is likely. Currently, the most promising scenario is that Moscow would return to weak (less than 0.5%) growth in 2016.

The ruble has fallen to about 67 against the dollar but 77 against the euro, which matters even more, due to the close economic relations between Brussels and Moscow.

What about medium-term expectations? In a benign scenario, Russian growth could still climb to 1.5 percent by the late 2010s and stay there until the early 2020s. But that’s a far cry from the pre-2008 BRIC-style growth of almost 7 percent.

Even these projections may soon have to be downgraded, due to negative feedback effects – including Russia’s sub-optimal growth, adverse spillover effects in Eurasia, accelerating escalation between US/EU and Russia, the economic fall of Ukraine, and rising geopolitical threats in the regional neighborhood.

In 2009, then-President Dmitry Medvedev launched a modernisation programme to decrease Russia’s reliance on oil and gas revenues and to create a more diversified economy. This is what most successful industrialisers have done through history, by gradually moving higher in productivity and the value chain.

Yet, energy continues to account for most exports and investment has been falling.

Fall of energy prices

Why are oil prices still low? According to conventional wisdom, the plunging energy prices are predicated on the effort by Arab countries, particularly Saudi Arabia, to drive down the price to make it commercially challenging for US producers to launch cutting-edge extraction technologies. In this view, leading Arab producers seek to sustain a crumbling oligopoly through low-cost responses.

An alternative explanation is that the military interests between the US, Saudi Arabia and the Gulf states, along with US-Egyptian relations, override commercial considerations. Low prices are not just economic realities but can serve geopolitical purposes.

According to Russia’s central bank (CBR), the likelihood of oil prices remaining below $60 barrel for a long time is probable. As those prices now hover around $44, the year-end figure is likely to stay close to or below $60. That’s $5 less than what US shale-oil producers claim can profitably increase production. Reportedly, two-thirds of Russia’s oil-processing firms are operating at a deficit.

At end of July, the CBR cut the key rate by 50 bps to 11 percent, while warning on cooling economy and downplaying inflation. Until recently, Moscow’s accommodative fiscal policies, monetary easing and large buffers have helped to absorb the shocks. However, investment has been falling.

In the pre-crisis years, Russia’s outward foreign direct investment (FDI) was about 16 percent of gross fixed capital formation. Last year, it was 14 percent. What has changed dramatically is the role of the inward FDI. It was over 15 percent in 2013 but plunged to barely 5 percent last year. As far as international investors are concerned, Russia needs greater progress in the implementation of structural reforms and rule of law.

As far as international investors are concerned, Russia needs greater progress in the implementation of structural reforms and rule of law.

Unsurprisingly, dissension is forming in the CBR as its monetary chief Dmitriy Tulin is speaking for easier credit and targeted lending to industry to rejuvenate the economy. In contrast, the central bank’s governor Elvira Nabiullina advocates traditional market-based policies. Both are concerned that the continued fall of the oil prices could drain further the CBR’s $360 billion in reserves.

Destabilisation ahead

Washington cannot afford to underestimate Russia’s strategic power and its popular unity. Russia remains the third biggest military spender in the world, right after the US and China. In the US, military expenditure fell by 7 percent last year, whereas in Russia the figure increased by 8 percent. While Putin remains committed to upgrade the Russian military at the cost of $600 billion through 2020, the US-EU sanctions have fostered support to these objectives among Russian people.

Most importantly, Russia is a nuclear superpower. While the US has an estimated 2080 deployed warheads, Russia’s corresponding figure is 1780 and the number of total warheads is actually greater in Russia (7,500) than in the US.

In the past year and a half, the sanctions have further deepened stagnation in Europe, while reducing the impact of euro economies’ fiscal policies and the effectiveness of the European Central Bank’s quantitative easing. The repercussions are reflected in diminished global growth, thus reducing growth prospects in the US as well, while contributing to rising anti-US and anti-EU sentiments in Russia.

As the oil prices continue to remain low and as the Fed prepares to hike the interest rates in the fall, emerging economies that are reliant on oil and gas, such as Russia, are likely to take the heaviest hit.

There are real disagreements between US and Russia, and Russia and EU. But sanctions will only amplify these differences, not reduce them. Shouldn’t the ultimate objective be to foster economic growth and minimise geopolitical friction?

Dr. Dan Steinbock is an internationally recognised expert of the nascent multipolar world. In addition to advisory activities, he is Research Director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore). He was born in Europe, resides in the US and spends much time in China and Asia. For more, see www.differencegroup.net

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